How the Tax Reform Entrenches the Welfare State

It has been said that a big piece of policy-reform legislation is perfect when it is equally disliked by everybody. If that is true with the Republican tax reform, the GOP can rest assure that they are close to perfection.

However, a bigger problem with the reform effort, above the punditry, for the first time ever, is that a tax reform seems to be designed primarily to secure tax revenue, and only secondarily to generate economic growth. At every point in the reform where the two goals collide, revenue appears to trump growth.

The ambition to secure revenue shows up most clearly on the personal-tax side of the reform. There, the GOP clearly has the ambition to limit tax cuts to low- and middle-income families, which in turn minimizes the upfront loss of tax revenue.

Contrary to the usual “tax cuts for the rich” rhetoric from pundits like Colorado State University economics professor Steve Pressman, the tax reform benefits middle-class families more than anyone else. Chris Edwards, director of tax-policy studies at the Cato Institute, explains:

The top 1 percent earns 21 percent of all income but currently pays 39 percent of all individual income taxes. As a result, a tax cut that reduced every taxpayer’s burden by the same exact proportion … would boost after-tax income by a higher percentage for the rich, simply because the rich pay a higher percentage of their income in taxes.

In other words, as Edwards correctly concludes, the bill adds to the progressivity of the federal income tax code. Bluntly: fewer, higher-earning taxpayers will pay an even larger share of all personal federal income taxes.

Already here, the tax reform actually reinforces the redistributive profile of the personal federal income tax code. But there is more: higher-income taxpayers derive a larger share of their income from investments and savings. Since the tax reform does not change taxes on dividends and capital gains, the effects of any tax cuts on work-based incomes quickly vanish as incomes rise. According to IRS income-tax data from 2015:

  • taxpayers making $20,000-$50,000 earn just over 80 percent of their income in the form of wages and salaries;
  • Taxpayers earning more than $1 million earn less than 50 percent of their income from wages and salaries;
  • Only 21 percent of incomes above $5 million is work based.

The composition of higher incomes reinforces the redistributive effect that Chris Edwards reports.

Again, this is no coincidence. Economic redistribution is the first economic priority of the federal government. Based on OMB data, two thirds of the federal budget is used for economic redistribution in one form or another. We shouldn't be surprised that redistributive policies defining outlays also get to determine the profile of the tax system that pays for those outlays.

By further concentrating the burden of federal income taxes on high-income earners, Congress also limits the growth effect from any cuts in personal-income taxes. The combination of tax cuts and expanded credits and deductions encourage people to join the workforce; at the same time, the reform’s increasingly progressive personal taxes will discourage people from pursuing a career. It pays less to earn a promotion and a raise — or to get a college degree, for that matter.

There is a similar policy conflict embedded in the corporate-tax side of the bill, and again, the ambition to secure tax revenue gets in the way of good growth policies.

On the one hand, the corporate-income tax goes down substantially, which will most likely help business investments. On the other hand, several other features put tax revenue above economic growth. As reported by the Wall Street Journal (December 5, print edition, section A), the Senate version of the tax-reform bill keeps the Alternative Minimum Tax (AMT) for corporations. This, the Journal reports, “gave the senators $40 billion over a decade to use on other priorities.”

The AMT goes into effect when a taxpayer deducts “too much” from his regular tax bill. In the Senate version of the tax-reform bill many smaller businesses could end up losing deductions as a direct result of the corporate AMT. Or, in the words of the US Chamber of Commerce:

Retaining the AMT in [the] reform is even more harmful than it is in its present form — among other things, it eviscerates the impact of certain pro-growth policies like the R&D tax credit and exacerbates the international anti-abuse rules.

The Wall Street Journal agrees, citing concerns from representatives of technology-heavy corporations such as Intel. Other industries, from pharmaceutical companies to agricultural equipment manufacturers, would also be harmed if the AMT neutralized the research-and-development tax credit.

Research and development generates growth first, then tax revenue. The AMT generates revenue and likely depresses growth in the future.

For the first time, a Republican tax-reform plan seems to have been designed with the pursuit of tax revenue on par with growth on its policy-goal list. It even appears as though the crafters of the reform have put tax revenue above growth when the two goals conflict.

Why would the GOP do this? There is only one possible explanation: they have given up on any ambitions of reducing the size of the federal budget. Their remedy for the Obamacare reform debacle, a repeal of the individual mandate without any other health-insurance market reforms, will dump millions more into — and increase the cost of — Medicaid. The idea of a paid-leave entitlement program is still alive.

In short: this tax reform appears to have been designed primarily to help secure future funding for a large, and growing, welfare state. Is this really what most Republicans in Congress wanted?

Image: Thomas Hawk.

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